by Joseph Joyce
China and the Debt Crisis
Sri Lanka is not the first developing economy to default on its foreign debt, and certainly won’t be the last. The Economist has identified 53 countries as most vulnerable to a combination of “heavy debt burdens, slowing global growth and tightening financial conditions.” The response of China to what will be a rolling series of restructurings and write-downs will reveal much about its position in the 21st century international financial system.
Debt crises are (unfortunately) perennial events. In the 1970s many developing countries, particularly in Latin America, borrowed from international banks to pay energy bills that had escalated after oil price increases enacted by the Organization of Petroleum Countries (OPEC). Repaying those loans became more difficult after the Federal Reserve raised interest rates in 1979 to combat U.S. inflation. Mexico announced that it could no longer make debt payments in August 1982, and other governments soon followed (see here for more detail).
The U.S. government supported negotiations that brought together the governments unable to make payments, the banks that had made the loans, and the International Monetary Fund. The banks were willing to restructure the debt while the IMF lent funds to the governments that allowed them to keep up their interest payments while staving off acknowledging their inability to pay off the debt. But this only delayed a final resolution of the crisis and led to a “lost decade” in Latin America. In 1989 Secretary of the Treasury Nicholas Brady proposed a plan that led to reductions of the loan principals in return for the issuance of “Brady bonds” by the debtor governments.
The U.S. allowed the IMF to take the lead during subsequent crises, including the East Asian crisis of 1997-98, Russia in 1998 and Argentina in 2000. As the member with the largest quota, the U.S. could influence the design and implementation of the IMF’s programs. It also took a more active role when U.S. interests were directly affected, as it did with Mexico in 1994-95. While U.S. attention was focused on its own crisis in 2008-09, the IMF took on the task of lending to middle- and low-income countries that were caught up in the economic shock waves of the financial collapse. The Federal Reserve, however, established currency swap lines with the central banks of other advanced economies as well as those of four emerging markets: Brazil, South Korea, Mexico and Singapore. The Fed reactivated the swap lines in March 2020 in response to the disruption in international credit markets caused by the pandemic and also set up a new facility to provide dollar funding to foreign official institutions.
China has taken a different position with regards to the debt of developing nations. Its state-owned banks have made bilateral loans as part of the Belt and Road initiative, with many of these loans made to African governments for infrastructure projects. But the amount of lending and the terms have not always been made transparent. Sebastian Horn of the University of Munich, Carmen Reinhart, currently Chief Economist at the World Bank while on leave from Harvard University’s Kennedy School, and Christoph Trebesch of the Kiel Institute for the World Economy developed a database of Chinese lending over the period of 1949-2017 which they published in a 2021 NBER paper, “China’s Overseas Lending.” They found “…that a substantial portion of China’s overseas lending goes unreported and that the volume of “hidden” lending has grown to more than 200 billion USD as of 2016.” Another study from AidData, a research lab at William & Mary, also documented Chinese lending to low- and middle-income countries, and found that many loans are collateralized against future commodity export receipts.
Some of these loans have already been restructured, with China pushing back repayment dates. If there is a systemic wave of defaults, the Chinese government must decide whether it will continue to negotiate directly with the governments that borrowed, or whether it will join the governments that belong to the Paris Club, a group of official creditors that attempt to devise sustainable solutions to debt problems, in designing a mechanism to reduce the volume of debt.
In 2020, the Group of 30 working with the IMF and the World Bank instituted the Debt Service Initiative (DSSI), which suspended debt service payments from low-income countries to official creditors, including China. Forty-eight countries participated in the program, which ended in December 2021. The DSSI has been followed by the Common Framework, which brings together official creditors and low-income borrowers to provide some form of assistance to insolvent nations. However, private lenders have not agreed to participate and only three nations have requested relief through the Common Framework. There are concerns about the process, and there will undoubtedly be calls for broad-based debt cancellation as countries with mounting food and energy bills seek relief.
The decisions that China makes regarding its participation in new initiatives have implications for its future role in the international financial system. The government has sought to enhance the role of its currency, the renminbi, and its share in the foreign exchange reserves of central banks has risen as trade with China has grown. Serkan Arslanalp of the IMF, Barry Eichengreen of UC-Berkeley and Chima Simpson-Bell, also of the IMF, have documented the decline in the relative share of dollar-denominated foreign reserves and the increase in renminbi-denominated reserves in “The Stealth Erosion of Dollar Dominance and the Rise of Nontraditional Reserve Currencies” in the Journal of International Economics (working paper here). They find, however, that the changes in the composition of foreign reserves involve more than the Chinese currency and show increases in the relative shares of the Australian dollar, the Canadian dollar, the Korean won, the Singapore dollar and the Swedish krona as wells. They attribute these changes in part to more active management of reserves by central bankers and also the existence of more liquid foreign exchange markets that facilitate non-dollar trading.
The use of the dollar-based international financial system as a financial weapon against Russia, including seizure of more than $300 billion of its central bank assets, could be an opportunity for another system to take its place, and there has been much speculation about the emergence of a Chinese-based rival. But Adam Tooze of Columbia University has pointed out that
“It (the dollar system) is a sprawling, resilient network of state-backed, commercially driven, profit-orientated transactions, lubricated by the easy availability of dollars, interwoven with American geopolitical influence, a repeated game in which intelligent players continuously gauge their advantages and disadvantages and the (very few) alternatives open to them and then, when all is said and done, again and again come back for more.”
A new system would take years to establish. Whether China’s government wants to allow its financial markets to become enmeshed in a global system by removing the remaining capital controls is unclear. The combination of drought, COVID-19 and its real estate crisis fully occupy the attention of the Chinese government. It may have to deal with a debt crisis among the developing nations however, and its response will be monitored for signs of how it sees its position within the global financial network of rules and institutions.